Who Pays the “Fair Tax”?

The term “fair tax” refers to proposals to repeal individual and corporate income taxes and several other taxes and replace them with a broad-based sales tax. How will this tax impact taxpayers of differing incomes? As it turns out, the answer depends on how the fair tax is structured. The following analysis will provide a preliminary peek at the potential impact of the fair tax on tax fairness in Minnesota.

The following analysis will assess the impact of a hypothetical fair tax proposal with the following characteristics: (1) all current state taxes are eliminated with the exception of the state property tax, the estate tax, the gas tax, the motor vehicle sales tax, and the motor vehicle registration tax, (2) the revenue generated by all other taxes will instead be generated by a new sales tax (a.k.a. the “fair tax”) applied to a much broader array of goods and services than are currently taxable, and (3) a “prebate” (a credit based on household size) will be provided to each household. This hypothetical proposal incorporates the basic elements seen in many fair tax proposals. This proposal will be modeled assuming revenue neutrality (i.e., no change in total state revenue relative to current law).

This analysis will be based on data for 2017 derived from the 2015 Minnesota Tax Incidence Study (MTIS). In examining the incidence of taxes by income, the MTIS divides households into ten equally sized groups referred to as “deciles.” These deciles are sorted by income from the first (lowest income) decile to the tenth (highest income) decile. The tenth decile is further broken down into three groups: the “next 5%” (i.e., the bottom half of the tenth decile), the “next 4%” (i.e., the top half of the tenth decile excluding the top 1%), and the “top 1%.” The income range of each group based on projected 2017 data from the 2015 MTIS appears below.

A problem with estimating the impact of a fair tax proposal is that there currently is not sufficient information to determine how the dramatic expansion of the sales tax base will impact the distribution of taxes across income groups. For the purposes of this analysis, it will be assumed that each income group’s share of total taxes paid under the fair tax (prior to the prebate) will be the same as under the existing state sales tax. Such an assumption overlooks shifts in taxes across income groups resulting from the sales tax base expansion. However, this assumption is unavoidable until more is known about the composition of the new fair tax base.

State taxes in Minnesota are moderately progressive. (It is only after factoring in significantly regressive local taxes that the overall Minnesota state and local tax system becomes regressive.) In the absence of the prebate, state taxes under the hypothetical fair tax proposal outlined above would become dramatically more regressive, with taxes shifted heavily toward lower income groups. The chart below shows the state effective tax rate (i.e., state taxes divided by income) by income group under current law and the hypothetical fair tax proposal with no prebate.

With no prebate, taxes on the bottom three deciles (i.e., households with income below $29,137) would more than double (although data for the first decile can be somewhat discounted due to data anomalies noted in the MTIS). The magnitude of the effective tax rate increase diminishes as income rises. For the eighth decile, state taxes increase by a relatively modest six percent. Beginning with the ninth decile, taxes begin to decline; the magnitude of the tax reduction increases as income rises. The top 1% would enjoy a state tax reduction of nearly 55 percent relative to current law under the hypothetical fair tax proposal with no prebate.

Clearly, the prebate is essential in order to avoid horrendously regressive tax consequences. The chart below shows the impact of the hypothetical fair tax proposal with an annual prebate of $4,000 per household. In order to maintain revenue neutrality, the fair tax rate will need to be increased to cover the cost of the prebate. The net result is a shift in state taxes among income groups relative to the no prebate scenario.

With a $4,000 per household prebate, state taxes fall by over two-thirds for the first decile (although, as noted above, first decile data can be somewhat discounted) and by 19 percent for the second decile. However, state taxes in the third through the bottom half of the tenth decile increase. For example, state taxes in the seventh decile (income from $66,363 to $86,340) increase by 19 percent. Apart from the first two deciles, only the top half of the tenth decile see any tax reduction relative to current law under this scenario; state taxes for the top 1% decline by over a third relative to current law.

It is possible to provide state tax reductions all the way through the fifth decile by increasing the household prebate from $4,000 to $6,000. However, regarding this, it should be noted that:

At $4,000 per household, the statewide cost of the prebate is already quite high, amounting to nearly $10.9 billion based on 2017 data—comfortably surpassing state spending on E-12 education, the single largest category of state general fund expenditures. Increasing the prebate to $6,000 would cost $16.3 billion annually, significantly more than combined state spending on E-12 education and health & human services—the two largest categories of state general fund spending.

While increasing the prebate from $4,000 to $6,000 will produce tax reductions for the first five deciles, it will result in greater tax increases for the seventh, eighth, and ninth deciles and the bottom half of the tenth decile. This occurs because the fair tax rate will need to be increased in order to cover the cost of the higher prebate. Meanwhile, the top half of the tenth decile will see smaller tax reductions under a $6,000 prebate relative to the $4,000 prebate, although the top 1% will still see a 26 percent state tax reduction relative to current law.

While this analysis of a hypothetical fair tax is hindered by the absence of data about how changes in the sales tax base will affect the distribution of taxes across income groups, it nonetheless indicates that:

The prebate is critical to reducing the regressivity of the fair tax.

At modest levels ($4,000 per household based on the fair tax parameters and assumptions used here), the prebate will reduce state taxes for very high and very low income households, but will increase taxes across a broad swath of middle-income households.

Expanding the size of the prebate can extend tax reductions into the lower range of middle-income households, but will result in even greater tax increases for the upper range of middle-income households.

It will be difficult, bordering on impossible, to increase the prebate—and consequently the fair tax rate—high enough to produce a tax increase for the top 1%. Based on this analysis, the fair tax proposal appears to be very beneficial to these high income households, which already enjoy the lowest effective tax rate in Minnesota based on the 2015 MTIS.

The higher the prebate, the higher the fair tax rate will have to be in order to pay for the prebate while still maintaining overall revenue neutrality.

This analysis does not resolve the myriad of claims and counterclaims regarding the advantages and disadvantages of the fair tax. However, it does constitute a beginning of empirical research on how the fair tax will impact the taxes paid by low, moderate, and high income Minnesotans.

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